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Excess Credit and Excess Limit

After computation of creditable foreign income taxes, next step is to compute foreign tax credit limitation.

Example:

USAco has U.S source income = 200

Foreign source taxable income = 100

Assume foreign tax rate = 45%

Assume U.S.A tax rate = 35%

Credit is limited:

Foreign tax credit is limited to the U.S tax on foreign source income (100 x .35 = 35)

Total tax on USAco taxable income = 300 x .35 = 105

Foreign Tax Return:

Taxable income = 100

Foreign tax rate = 45%

Foreign tax = 45

U.S Tax Return:

Taxable income = 300

U.S Tax rate = 35%

Pre-credit USA tax = 105

Foreign tax credit = 35

U.S tax payable = 105 – 35 = 70

No Limitation:

Foreign Tax Return:

Taxable income = 100

Foreign tax rate = 45%

Foreign tax = 100 x .45 = 45

U.S Tax Return

Taxable income = 300

U.S tax rate = 35%

Pre-credit tax = 105

Foreign tax credit = 45

U.S tax payable = 105 – 45 = 60

Exemption:

An individual with $300 or less of creditable foreign income taxes may elect to be exempt from the foreign tax credit limitation, provided he or she has no foreign source income other than passive investment income. The $300 amount is increased to $600 in the case of married persons filing a joint return.

Relative Tax Rate:

The relation of U.S tax rate and foreign tax rate is a major determinant of whether a taxpayer is in an excess limitation or an excess credit position. Taxpayers will be in an excess limitation position when the foreign tax rate on a taxpayer’s foreign source taxable income is lower than the U.S rate, and in an excess credit position when the foreign tax rate is higher than the U.S tax rate.

Example:

USAco has foreign taxable income = 100

U.S source taxable income = 0

U.S.A tax rate = 35%

Case 1:

Foreign tax rate = 30%

Foreign Tax Return:

Taxable income = 100

Foreign income tax rate = 30%

Foreign income tax = 100 x .30 = 30

U.S Tax Return:

Taxable income = 100

U.S tax rate = 35%

U.S.A tax = 35

Less foreign tax credit = 30

Balance U.S tax payable = 35 – 30 = 5

Case 2:

Foreign tax rate = 40%

Foreign Tax Return:

Taxable income = 100

Foreign income tax rate = 40%

Foreign income tax = 100 x 40% = 40

U.S.A Tax Return:

Taxable income = 100

U.S tax rate = 35%

Pre-credit tax = 35

Foreign tax credit = 35

Balance U.S tax payable = 35 – 35 = 0

 

References:

Practical Guide to US Taxation of International transactions 9th Edition

Robert J. Misey Jr.

Michael S. Schadewald

Publishers: Wolter Kluwer, CCH Incorporated.